COST OF CAPITAL
Cost of capital is the minimum return expected by the investors. It is the rate of return that a firm must earn on its project investments to maintain its market value and attract funds from the investors.
It is a discount rate which determines the present value of estimated fuuture cash proceedds and decides whether the project is worth undertaking or not.
MEASUREMENT OF COST OF CAPITAL
For calculating the cost of capital of the firm, it is essential to consider the different sources from which the funds are required by the firm. It includes Debt financing, Preference share capital, Retained earnings, Equity capital, Term loans, etc.
The cost of each component of capital has its cost called ‘Specific Cost of Capital’, when these are combined or total effect of cost of capital procurement of such capital from different sources is called as ‘Weighted Average Cost of Capita(WACC)’ or ‘Overall cost of Capital’
WACC = Cost of Equity + Cost of Preference Shares + Cost of Debentures
FACTORS EFFECTING COST OF CAPITAL
There are many factors which effect the cost of capital and the decisions involved, they are as follows:
# BUSINESS RISK
It is the risk to the firm of being unable to recover operating costs due to various external and internal factors that effect the business.
# FINANCIAL RISK
It is the risk of being unabble to cover required financial obligations such as interest and preference dividend payments.
# EXPLICIT COST
Discount rate that equates present value of cash inflows to the extent of the amount recieved. It is the rate that a firm pays to procure finance, when funds are raised explicit cost will raise.